Options Theory: Hedging Basic Series Part 1 – What is Hedging?
October 22, 2017
Last update: August 2021
Hedging Basic Series [Free Articles]
- Part 1: What is Hedging?
- Part 2: Why do Traders Hedge?
- Part 3: When to Place Your Hedge
- Part 4: How to Hedge a Naked Put
Time to don the gardening gloves and find the clippers. We’re about to kick-off what is bound to be an enlightening multi-part discussion on hedging. You’ve heard the cool kids talk about it. Maybe you’ve even tried your hand at hedging a trade or two. Whether you’re brand-spankin’ new or a grizzled hedging vet looking to hone your skills, you’ve come to the right place.
With our recent wrap-up of the backtesting series, it’s time to forge into new territory. And I must be honest – hedging is a big topic. To narrow our focus, I’m going to sidestep the whole pandora’s box of portfolio hedging and talk instead about hedging individual positions. We will allow the classic questions of What, Why, When, and How to be our guides.
And if the announcement of my punting on portfolio hedging is bumming you out, worry not. We’ve investigated the topic backward and forward in the forthcoming Ultimate Bear Market Survival Guide. So stay tuned and prepare to be dazzled by this interactive video series.
What is Hedging?
Hedging means you are entering an offsetting trade to reduce risk. It’s as simple as that. But let’s break it down to make we understand precisely what is meant. There are three parts to the sentence. First, we are entering a trade. That means when you hedge you are adding a new trade as your mechanism for reducing risk. No doubt there are other ways to minimize risk like exiting part or all of your position, but that’s not hedging.
Second, we are entering an offsetting trade. That means you are deploying a trade that will profit in environments where your original position (aka your parent position) will lose. For example, suppose you have a bullish position in AAPL stock. An offsetting trade, then, would be anything bearish. That is, anything that makes money when AAPL stock falls in value. If you think about it, there are a lot of ways to acquire bearish exposure to AAPL. You could short a highly correlated ETF like QQQ. You could buy a put option or sell a call option or enter some type of bearish spread trade. All of these would qualify as offsetting trades.
Alternatively, if you held a bearish position in AAPL stock that you were looking to offset, you would add a bullish trade. You could buy a highly correlated ETF like QQQ. Or you could buy calls, sell puts, or enter some type of bullish spread trade.
Third, we are entering an offsetting trade to reduce risk. That means that after adding the new trade, the risk of your overall position should be less. The most direct way to measure this is to look at the delta on the stock in question. Remember, delta measures our directional exposure on the stock. Specifically, how much money you make/lose if the stock rises $1. The higher the delta, the more exposure you have (if you need an in-depth refresher on delta, then I highly recommend watching module 4 of the Options 101 video series [PRO Members only]). Here’s an example.
Long 100 shares of stock = +100 delta
To hedge, I purchase an at-the-money put option with a -50 delta.
Long one put option = -50 delta
Overall position delta drops from +100 to +50. By adding the put, we reduced our risk by 50%.
Here’s what it looks like in ThinkorSwim when you view the Position Statement:
I suspect today’s commentary leaves you with more questions than answers. And that’s a good thing. It means I’ve whet your appetite and you’re departing with the desire for further enlightenment. Now that we understand what hedging is it’s time to discuss why someone would go through the hassle of hedging a position versus simply exiting. Stay tuned for next week’s missive where we’ll discuss just that.
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Options Theory: Hedging Basic Series Part 2 – Why do Traders Hedge?
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good read. left a bit wiser
Pretty excited about this subject. I’m curious what you have to say. I’ve been working on this subject albeit for my overall portfolio delta and Vega. Close enough. Good call.
Thanks guys! I’ve got plenty more comin’ down the pike.